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Advantages and Disadvantages of the Lender of Last Resort and its impact upon the recent financial crisis

Updated on June 28, 2017

Introduction

The role of central banks as lenders of last resort had never been tested so much as in the global financial crisis which began with the bail out of Northern Rock in the UK in 2007 and reached a peak in the wake of Lehman Brothers filing for chapter 11 bankruptcies in the USA on 15 September 2008. However a view of the advantages and disadvantages of their role very much depends on whether a political or commercial stance is taken.

The rate at which the crisis developed was unprecedented and there was a need to react very swiftly from politicians and bankers alike because there was a fear that the whole of the global banking system was going into meltdown. Looking back at events it is relatively easy to assess how things went wrong so quickly and there were lessons learned from the crisis which resulted in some sensible measures being put in place which offered greater protection to individual depositors. However with the focus in more recent times switching to sovereign as opposed to corporate debt the same arguments about the value of LOLR still prevail.

In order to look at the political and economic factors which were in play it is useful to look in more depth at the institutions which were under threat of imploding both in the UK and the United States.

Advantages and Disadvantages of LOLR

In the five years before the crisis global interest rates were low and in real terms the cost of borrowing and raising capital was cheap. Numerous financial institutions, but in particular the investment banks took greater risks than before. Impossible to prove but arguable they did so in the likelihood that the unthinkable to happen they would be bailed out by central banks rather than be allowed to fail. Hence it can be argued this led to a great deal of complacency increased the risk of losses made in the private sector being foisted on the taxpayer.

The opposite view is that without the intervention of central banks there would be no simple or effective way of nipping a financial crisis in the bud. From a political perspective this is not acceptable as the impact of certain financial institutions failing could go very deep. Not only could this lead to political instability but investment markets going haywire and out of control.

Northern Rock

This was a UK mortgage who lent aggressively by offering mortgages which stretched normal lending criteria in a period when property prices were booming. They borrowed funds on the money markets over a short term and then lent mortgages over a far longer period. All the while their funding remained available there was little problem but as soon as liquidity in the interbank market dried up they were in trouble. There was a run on the deposit side of their business with lengthy queues of customers looking to withdraw their savings, of which only the first £30,000 was guaranteed by the depositor’s compensation scheme. Politically it was not acceptable to the Labour administration to allow the institution to fail and the result was a government takeover of Northern Rock with the quoted shares in the business being suspended and becoming worthless. The institution was later split into a good bank (savings) and a bad bank (mortgages) with the intention of the amount of taxpayers’ money it cost to nationalise the Northern Rock being recouped from a future sale of the business. Ironically the "good" bank was sold to Virgin Money in 2011 for £747m which meant not all of the taxpayer’s money being recovered.

Freddie Mac and Fanny Mae

These were both mortgage lenders in the USA which dwarfed the Northern Rock operation and they had to be bailed out by the US government at a cost of $200 million to the US taxpayer. As in the UK the consensus was that the government could not allow the institutions to fail for fear of the social fall out despite its meaning the US taxpayer being saddled with billions of dollars of costs all emanating from losses made in the private sector. The US senator John McCain succinctly pointed out the dilemma for politicians which is central to our theme when he said "We need to keep people in their homes, but we cannot allow this to turn into a bailout of Wall Street speculators."

Lehman Brothers

By contrast this investment bank was allowed to fail. There was much criticism of the US government for allowing this to happen when it had tacitly backed the survival of a similar company Bear Stearns only months earlier when this investment bank was taken over by JP Morgan. Bear Stearns had been operating in similar markets and taking equally large risks by actively trading in the securitised mortgage debt market, much of which contained the so called "toxic debt" associated with subprime mortgages.

On the face if it Lehman’s although very highly leveraged was still technically solvent when it filed for chapter 11 as it had assets of $639 against debts of $619. However the US property market had already turned and repossessions were rising alarmingly. Only days after the rating agency Moodys threatened a downgrading of Lehman's credit worthiness it went out of business.

It is hard not to conclude that Lehman’s was allowed to fail because it was thought this would not affect the man in the street to anything like the same extent as a mortgage company or deposit taker going out of business. After all this was an investment bank and whilst it meant there would be 25,000 employees out of a job it is apparent the authorities thought this would not result in a contagion across the US or global economy. As things transpired the authorities could not have been more wrong as this event triggered the so called "credit crunch" with banks almost overnight becoming fearful of lending to each other because a precedent has been set without the central banks intervening when such institutions had come to expect this as the norm. With the failure of Lehman’s there were many who saw this as central bankers wishing to flex their muscles and demonstrate that no institution should assume it had a divine right to be saved from failing.

Conclusion

Although there has been an attempt to impose tighter restrictions on banks since the start of the crisis with more controls in place and here in the UK higher levels of deposit guaranteed in the event of an institution failing, the scars of the financial crisis have not yet fully healed. The intervention of LOLR is not always perfect but on the evidence of the aftermath of the demise of Lehman’s the world is probably a safer place with central banks than without them.

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